Investment Account Series: RRSPs for Retirement

Let's continue our Investment Account Series. After talking about the TFSA last week, I'm sure you've been left with no doubts about my enthusiasm in using the TFSA for long term investing. Now on to the RRSP.

It's "RRSP season" again, so expect lots of talk from banks about saving and investing for the future. A lot of this talk is focused on selling you RRSP Loans, maybe massaging you into an overpriced mutual fund, and really emphasizing that tax refund. But is the RRSP all it's cracked up to be? And is it the best account to save in for retirement? What is the best way to use an RRSP? What do you do with the tax refund?

I plan to write several pieces about the RRSP because of the many rules, variations, and intricacies associated.

What is the RRSP

Registered Retirement Savings Plans are another vehicle for investments that carry tax advantages. Again, just like the TFSA, the RRSP is not a product in itself. It's just a special account and you can use it to purchase investment products. If you open an RRSP account with one of the big banks, you will generally be coaxed into purchasing their overpriced mutual funds which charge about 2-3% fees annually on your money. To save gobs of money on fees, I use Questrade and opened a self-directed RRSP account to buy ETFs.

The RRSP differs from TFSA in its tax advantage structure. The RRSP saves you money in taxes by deferring tax payments now to paying tax on withdrawals in future years.

In other words, you get a tax refund at your marginal tax rate now by putting money into your RRSP, but you pay income taxes later when you withdraw money from your RRSP. This typically has been promoted for high earning working years and low spending retirement years. But it can be used effectively for any situation where you want to move money from high income years to low income years (raising kids, school, sabbatical, job loss, etc).

Should You Use RRSPs to Save for Retirement

This is a loaded question and depends on your personal situation. Generally one only benefits from investing through the RRSP instead of a TFSA if you use your tax refund for investing.

Second, you need to somewhat accurately be able to estimate your future spending needs in retirement. If you earn lots of money now, but spend little and plan to maintain your low spending, investing in an RRSP makes a lot of sense!

Third, the RRSP benefits people who are high earners. If you earn less than around $50,000 a year the benefits of using an RRSP for retirement can be minimal.

Finally, if your spending will be high in retirement, or if you will be receiving a generous pension in retirement, the RRSP is not that great.

Great RRSP Retirement Scenario

Let's consider an ideal example of using an RRSP for retirement saving.

Stacy, a 30 year old Ontario resident, earns $105,000 a year. She spends $60,000 and expects both her spending and earnings to keep pace with inflation. She wants to retire at 60 years old and will mainly fund her retirement with her RRSP income, some non-reportable TFSA income, plus any government benefits.

Stacy knows that tax rates jump to 43.3% in Ontario at about $90,500, so she decides to invest $14,500 in her RRSP account. She gets a tax refund of $6,290 on her original RRSP contribution which she uses for next year's contribution. Without the tax refund, she would only have been able to contribute $8,210 per year for retirement in other accounts.

At 60 years old, she will have an inflation adjusted RRSP account worth $1,150,000 because she invests in a Balanced Portfolio. She decides to withdraw 6% of her RRSP amount annually (until RRIF rules kick in at 71), so her RRSP withdrawal income will be $69,000. Her blended tax rate on $69,000 is just 21.2%, or $14,600 per year. Due to this future tax owing, the true net value of her RRSP account is actually just $906,200.

To recap, $14,500 of "before-tax" money going in for 30 years at 6% equals $906,200 in "after-tax" money going out at a 21.2% tax rate. If, without investing the RRSP tax refund, she would have invested just $8,210 per year, at the end of her 30 year investment timeline she would only have $650,000.

As you can see, in this situation the RRSP tax advantage gave Stacy an enormous financial benefit, increasing her net assets by around 40%!

Less Ideal RRSP Retirement Scenario

Max, a 30 year old Alberta resident, earns $70,000 a year. He spends $50,000 and doesn't expect that to change. However, in retirement he plans to move to higher-taxed Nova Scotia where most of his family lives and the overall cost of living is a bit lower. By reinvesting the tax refund every year, he can invest $7,500 per year in his RRSP. His marginal tax rate is 30.5% so his refund on his RRSP contribution is $2,290. Without the refund he could otherwise contribute $5,210 to investments.

His savings rate is a little lower than Stacy, so he needs to work longer to meet his savings goals, but at 65 years old he will have $835,000 in his inflation adjusted RRSP account. He also withdraws 6% of his RRSP account annually for an income of $50,100. His blended tax rate on this income in Nova Scotia is 21.9%, or $11,000 per year. Due to this tax liability on RRSP withdrawals, the net value of his RRSP account is $652,000.

In recap, $7,500 of "before-tax" money going in for 35 years results in $652,000 available after tax is paid. If he would have invested $5,210 in a different account for 35 years, the account would be valued at $580,000. Max still comes out ahead by using the RRSP because he reinvested his tax refund, but his net assets only increased 12.4%. Hopefully his taxable income of $50,100 doesn't disqualify him for any seniors benefits as this would substantially increase his effective tax rate and make the RRSP a potentially bad decision.

Bad RRSP Retirement Scenario

Jill, a 30 year old Alberta resident, earns just $45,000 doing contract and part-time work. She dutifully invests the maximum allowed $8,100 in her RRSP each year as the big banks convinced her this would be smart (because of the tax refund). Her marginal tax rate is 25% so her refund is $2,025 and she uses the "free" money to pay for her new summer closet and an extra vacation!

At 60 years old, Jill will have $640,000 in her RRSP account which will spin off $32,000 a year at a 5% withdrawal rate (she expects to live long and needs money for a longer retirement). She moves to PEI to be close to friends and her blended tax rate on $32,000 of income is 17%, leaving her with $26,560 in net income.

What if Jill would have invested the $8,100 in different accounts? Let's say $5,500 per year went into her TFSA and the balance of $2,600 in a Cash/Margin Account (with an after tax return of 5.5%). Her TFSA would have $434,800 tax-free money for $21,740 of non-reportable income at a 5% withdrawal rate. Her Cash Account would have $188,330 for $9,415 of tax-advantaged income in the form of Canadian dividends or capital gains. This income would be tax free at Jill's income level.

By not using the RRSP, she gets $31,155 in net income. That's a 17% higher net income than with the RRSP! Plus her tiny reportable income of $9,415 per year would put her well below the poverty line and she could line up for benefits as a low income senior.

What if she didn't know about the TFSA and just invested $8,100 in a Cash/Margin account which grew at 5.5%? She would only have $586,750 instead of the $640,000 in her RRSP. But, at a 5% withdrawal rate in Canadian dividends (3%) and capital gains (2%), she would earn $29,335 again all tax free! That's despite the lower rate of return in a Cash/Margin account.

Do your math before choosing to use RRSPs for retirement saving! And if it works for you, always reinvest the tax refund. It's not free money, it's simply taxes you don't have to pay now but you will have to pay later!

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2 Replies to “Investment Account Series: RRSPs for Retirement”

Thanks for this run-down. Super interested to hear your thoughts about RRSP-use when one has a government pension. Like you, I work for the government, in my case the feds and have a generous retirement pension where I can expect to make good money upon retirement, even more than I am making now in my early 30s.

In my case does it make sense to contribute to an RRSP. My income is hovering around 80,000 a year and just below a big jump when I close in on the 43/44% income tax rates in Ontario.

I have currently deposited $25k but not made the full deduction, I only portion a bit to bring me below a certain tax bracket. And yes, while I dont have much RRSP contribution room, as I a contribute lots to my pension, I do accrue a few thousand dollars with of room each year.

I personally contribute to a RRSP with my pension and believe most people should, especially if early retirement is in the cards.
If you are planning to work until full pension, a RRSP should still be used before non-registered. An argument could be made that TFSA should be prioritized in this situation.
RRSP withdrawals, as well as pension income can be split with a spouse. You can also use your RRSP to do some interesting things with non-arms length mortgages to get tax deductions on withdrawals.
Just a note, it rarely makes sense to defer RRSP deductions after the contributions are made. Unless you are expecting a big raise very soon that bumps you well into the next tax bracket after the pension adjustment correction, you are likely best to take the deduction ASAP. In the future, consider putting all that money in a non-registered account and investing it. The in February sell some of the investments to make the desired optimal RRSP contribution/deduction.

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